Liability Management and Special Situations: When Traditional Finance Falls Short

With increasingly challenging macroeconomics and geopolitical headwinds, many companies are finding that their existing capital structure, negotiated in more benign times, no longer fits the business it was meant to support. However, gaps within that capital structure may allow the company to reshape its financing arrangements to access further liquidity. This is when liability management comes into play.

This article in our series on capital solutions, considers what happens when a capital structure comes under pressure and the familiar routes out, whether a straightforward refinancing, fresh sponsor equity or discussions with a supportive lender, are unavailable, too slow or too expensive, meaning that more creative solutions need to be found.

When Traditional Finance Falls Short

For a healthy company, refinancing is a question of timing and pricing. A maturing facility is replaced by a new one, a sponsor injects further equity, or a lender agrees to roll its exposure. For a company in stress, its options narrow: lenders grow cautious as performance deteriorates, new money becomes harder to source on commercially acceptable terms, and the cost of conventional refinancing can climb to a level the business cannot tolerate.

European banks have continued their measured retreat from sub-investment-grade lending, a theme touched on earlier in this series, and the institutional markets remain alert to a weakening credit story. When a borrower cannot simply refinance its way out of difficulty, attention turns instead to the documentation already in place and the creditor group already at the table. The question becomes, how can liquidity be achieved within the existing financing terms subject only to the consent of the borrower and a cooperative majority?

The Rise of Liability Management

Liability management exercises (LMEs) are a familiar concept in the United States, where various cultural and market dynamics have resulted in their prevalence. LMEs have historically been less utilised in Europe for reasons which we touch upon later, but they are now becoming increasingly common. An LME is the technique by which a borrower, usually with the backing of its sponsor and a majority of its lenders, reshapes its existing debt rather than replacing it. The aim is to create a liquidity runway by extending maturities, raising new money, and reducing or reprofiling debt, consensually where the lender group is aligned but sometimes coercively where it is not. Over the past few years, these techniques have moved from the margins of European special situations towards the mainstream.

Two developments explain much of the shift:

1. Loan and bond documentation has become considerably more permissive, with cov-lite terms, generous baskets and elastic definitions giving borrowers room to manoeuvre in a way that earlier vintages of credit agreements never allowed. The covenant flexibility once associated with the largest, bond-style financings has worked its way into mainstream European syndicated term loan and even some unitranche deals, many of which now carry high-yield-style “Restricted Group” architecture in place of the traditional LMA “Group” concept. The same drafting has filtered steadily down from large-cap deals into the mid-market and, where the documentation permits, a borrower and cooperative majority can act in a way that binds (and potentially disadvantages) the minority.
2. At the same time, the creditor base has fragmented: banks, CLOs, credit funds and distressed investors now participate in the same structure and pursue very different strategies. US players and their advisers who are familiar with LME techniques state-side look to replicate the playbook in their European investments.

Typical Forms of LME

Amend-and-extend: The most consensual of the techniques. Lenders agree to extend maturities, generally in exchange for improved economics, whether a higher margin, additional fees, tighter covenants or further security. An amend-and-extend buys time and avoids a more disruptive process, and it remains the first port of call for many stressed credits. A borrower may pair an extension offered to consenting lenders with “exit consents” that strip covenants or protections from those who decline, so that holding out leaves a lender in a worse position than participating. A “snooze-and-lose” provision, under which lenders who fail to respond within a short window are disregarded or deemed to consent, can lower the threshold needed to carry the amendment.

Exchange offers and rescue financings: Where the balance sheet needs more than some extra time, a borrower may invite creditors to exchange their existing debt for new instruments carrying a different priority, maturity and/or coupon. Exchange offers are frequently paired with a new-money tranche, the providers of which take an enhanced position in return for their support and the fresh capital they provide. Rescue financings (i.e., new money advanced to a business in distress, typically secured and senior-ranking) sit at the sharper end of the same spectrum.

Drop-downs: A drop-down involves moving assets, often the more valuable or unencumbered ones, into an unrestricted subsidiary that sits outside the existing security and guarantee net through a “trap-door” in the covenants. That subsidiary can then raise financing against those assets, giving the new lenders priority access to value that the existing creditors had assumed was available to them. The technique relies on the headroom left by permissive investment, restricted payment and asset transfer covenants.

Uptiers: An uptier reorders priority within the existing structure. A majority of lenders agree to provide, or to backstop, new super-priority money and, in the same step, amend the documentation to subordinate the claims of the non-participating lenders, who find their once-equal ranking debt has been pushed down the waterfall. An uptier turns on the voting and amendment mechanics of the credit agreement: what a majority can do without the minority’s consent, and what protections, if any, the minority has kept for itself. European documentation tends to make this harder to engineer, because subordinating one lender to another, or reordering the security waterfall, is usually an all-lender matter under the intercreditor agreement rather than something a simple majority can impose. That said, some top-tier sponsor facilities now permit a new super-priority tranche to be introduced on a supermajority vote and combine this with permissive debt-buyback provisions, which together can open the door to an uptier-style outcome.

Creditor-on-Creditor Violence

LMEs have given rise to a phenomenon now widely known, including in Europe, as “creditor-on-creditor violence.” The phrase captures the plain reality that an LME often advantages one group of creditors at the direct expense of another within the same class. The winners are those inside the cooperating majority; the losers are the minority left behind, subordinated by an uptier or stranded by a drop-down that has moved value beyond their reach.

There are various protections in European situations that reduce the use of (or the aggressive nature of) LMEs, including directors’ duties regimes. English law also sets some limits on how far a majority may go. The principle that a majority must exercise its power for the benefit of the class as a whole, rather than to confer special advantages on itself, was applied in Assénagon, where the court struck down an exit consent that left dissenting bondholders facing the near-total expropriation of their rights for nominal value. How much coercion, short of that outcome, English law will tolerate remains unsettled, which gives both proponents and challengers something to argue about.

Lenders have responded to LMEs by bargaining for stronger protections at the outset, including sacred rights subject to all lender consent, anti-subordination and anti-asset-transfer provisions, and tighter controls on what a majority may amend. However, as these contractual “LME blockers” begin to appear in documents, borrowers and majority lenders will continue to scrutinise documents and capital structures creatively to craft new LME techniques.

Lenders may also look to defensive cooperation agreements, under which a blocking group commits to act together and not to deal with the borrower individually. These have crossed into the European market as a way of resisting “divide and conquer” tactics.

For sponsors and borrowers, the judgement is whether the value an aggressive structure might create outweighs the reputational cost and the risk of challenge. For lenders, the recurring lesson is that documentation agreed in benign conditions is tested most severely in adverse ones, and that the protections worth having are the ones negotiated before the stress arrives.

Whilst the formal restructuring toolkit across European jurisdictions, such as England’s restructuring plan and scheme of arrangement, remain powerful tools for imposing a deal on dissenting creditors through the courts, for many borrowers an LME offers a faster, quieter contractual remedy which, absent challenge, is a less expensive route to the same commercial end. That said, LMEs do not escape litigation risk; restructuring plans provide certainty at the point of implementation as dissenting creditors have a forum to voice their objections. LMEs do not, and are therefore sometimes subject to costly and time-consuming litigation after the event.

LMEs and the Mayer Brown Capital Solutions Team

Liability management sits squarely at the intersection of the disciplines that the Capital Solutions platform draws together. These exercises draw on the expertise of restructuring lawyers who understand stressed dynamics and the leverage each party holds, finance lawyers versed in the documentation and market trends, corporate lawyers attuned to sponsor dynamics, and litigation specialists with a clear eye on the risk of challenge.

Mayer Brown’s restructuring, leveraged finance, special situations, and corporate practices advise creditors, borrowers and sponsors across the full range of liability management techniques in the United Kingdom and across Europe. We act for private credit funds deploying new money into stressed situations, for lender groups defending their ranking against an aggressive exercise, and for borrowers and sponsors working to create runway within the structure they already have. Because our practice spans the whole of the capital structure, we see these situations from every seat at the table, which is precisely the vantage point that liability management demands.